As a business buyer, it’s easy to be dazzled when a seller shares financial statements that show the company is flush with profits. This business seems like a cash cow–but is it, really? That’s the question a quality of earnings (QofE) report seeks to answer.
If you don’t challenge the figures you’re given and ask questions about their accuracy, you may find out later that the rosy picture of ample profits that the seller painted is an illusion.
Let’s examine exactly what a quality of earnings report is, how you obtain one, and how it helps you assess a potential acquisition.
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Quality of Earnings Defined
What is quality of earnings? A routine step in the due diligence process, quality of earnings assesses whether the revenue and profits you see on a company’s balance sheet are accurate and likely to be ongoing. You want to find out if the top-line revenue and net earnings truly represent normal, sustainable results for this business.
Quality earnings don’t throw in special or non-recurring items. The figures should be arrived at using conservative, generally accepted accounting principles, not aggressive tactics. Finally, income should be coming from the company’s primary business activities, not one-time events.
The findings from research into earnings quality are compiled into a quality of earnings report that often provides a more realistic snapshot of the business’s future potential.
Key Benefits of Doing a QofE When Acquiring a Business
Why is it important to do a quality of earnings report? It’s an important step in due diligence because business is not all smooth sailing–and sellers are not always 100% truthful.
Often, unusual events happen in the life of a business that can skew a company’s financials. Sellers may also obscure problems in the business by neglecting to include key items or otherwise engaging in ‘creative accounting.’
Researching how a company’s gross and net income were calculated can reveal anomalies that change the outlook for future performance–and possibly, your level of enthusiasm for buying the business.
Who Prepares a Quality of Earnings Report?
A quality of earnings report is usually prepared by a financial professional on the buyer’s due diligence team. They should be an independent certified accountant who can look at the figures with fresh eyes.
Smart sellers who wish to have a smooth due diligence process may also commission a QoE report. This report gives the seller a chance to find and correct any problems that a buyer might see as red flags in their current profit-and-loss statements.
How Is The Quality of Earnings Ratio Computed?
Before a financial pro dives into a company’s figures in detail, they may do a quick calculation to just get a snapshot of whether quality of earnings seem to be high or low. This is done using the quality of earnings ratio (also known as the quality of income ratio).
Here is the formula for calculating the earnings ratio:
Quality of earnings ratio = Net cash from operating activities DIVIDED BY Net Income
Net income divided by net operating cash should produce a result that’s higher than one.
If net income is higher than cash from operations, some revenue must be coming from unusual, non-core, or one-time sources. This is a red flag to look deeper into sources of cash.
Factors That Can Affect The Quality of Earnings
What situations can impact quality of earnings and distort the picture of how profitable the business will be in future? Here are some of the most common issues:
- Discontinued operations that aren’t removed from income
- Shifting of income or expenses from one year to another to improve the net-income picture
- Improperly calculated run rate for revenue or costs (recurring costs recorded as one-time costs, for instance)
- Transactions at non-market rates, often to related parties
- One-off revenue that’s projected to be ongoing
- Failure to report noncash transactions or discounted amounts on sales
- The loss of any key contracts or customers that will reduce future revenue
Asking pointed questions about sources and timing of cash and expenses can help stress-test the earnings statement to see if earnings are as portrayed, or if in fact the quality of earnings is lower than initially stated.h
Two Examples of Quality of Earnings
To understand how this all works in practice, let’s look at two businesses that appear to have similar performance.
Company A reports $1 million in income, and $300,000 in net profits.
Company B also reports $1 million in income, and $300,000 in net profits.
What’s behind the figures at Company A? All of the $1 million in reported income is from ongoing operations. The $700,000 in reported expenses were recorded using standard accounting methods. The $300,000 in profit appears to be legitimate and likely to repeat in future years.
Over at Company B, the story is different. On closer examination, it turns out that $150,000 of the reported income came from selling off equipment, a one-time source of income. Also helping to enhance profits are a couple of relatives who are employed ‘off the books,’ with the $75,000 value of their salaries omitted from the expense calculation.
Excluding that one-time income and adding the missing salaries to expenses yields a dramatically different result: Just $75,000 in sustainable profit.
Omitted expenses and unusual income sources are common ways that business owners may muddy the picture of how profitable that business would be under new ownership.
Don’t Buy a Business Without a Quality of Earnings Report
As you’ve seen, the quality of earnings report is essential for assessing a company’s true financial health and future profit potential. Once you understand how misleading accounting practices can create a false portrayal of a business’s success, you can see it’s essential to have a quality of earnings report done by a qualified financial professional before you buy a business.